Betting on the Best: Alphabet - Whitney Tilson Kase Learning February 27, 2018 This presentation is posted at: www.tilsonfunds.com/TilsonGOOG ...
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Betting on the Best: Alphabet
Whitney Tilson
Kase Learning
February 27, 2018
This presentation is posted at:
www.tilsonfunds.com/TilsonGOOG.pdf
Disclaimer
THIS PRESENTATION IS FOR INFORMATIONAL AND EDUCATIONAL
PURPOSES ONLY AND SHALL NOT BE CONSTRUED TO CONSTITUTE
INVESTMENT ADVICE. NOTHING CONTAINED HEREIN SHALL CONSTITUTE
A SOLICITATION, RECOMMENDATION OR ENDORSEMENT TO BUY OR
SELL ANY SECURITY OR OTHER FINANCIAL INSTRUMENT.
WE MAKE NO REPRESENTATION OR WARRANTIES AS TO THE
ACCURACY, COMPLETENESS OR TIMELINESS OF THE INFORMATION,
TEXT, GRAPHICS OR OTHER ITEMS CONTAINED IN THIS PRESENTATION.
WE EXPRESSLY DISCLAIM ALL LIABILITY FOR ERRORS OR OMISSIONS IN,
OR THE MISUSE OR MISINTERPRETATION OF, ANY INFORMATION
CONTAINED IN THIS PRESENTATION.
-2-
I was very skeptical of Alphabet when it first went
public, as I outlined in a presentation I gave at
Alphabet’s headquarters on Nov. 21, 2014 entitled:
A Google Skeptic Eats Crow –
And Thoughts on the Stock TodayExcerpt from A Google Skeptic Eats Crow, 11/21/14
My Worst Call Ever (1)
• In a column published on The Motley Fool website on July 30, 2004
entitled The Tech Stock Opportunity, I wrote:
• Fertile ground
Despite my reservations about the tech sector, I actually think that it is -- or
at least should be -- fertile ground for value investors for the simple reason
that most of the investors in the sector are irrational, momentum-driven
speculators. Thus, the sector is characterized by wild mood (and therefore
price) swings, as investors overreact to favorable or unfavorable
developments. While overvaluation has been the more common state of
affairs during the past decade or so, there have been a few points --
October 2002 most recently and, to a lesser extent, March 2003 -- when
tech investors panicked and all sorts of tech stocks were downright
cheap…
Not only does the tech sector offer occasional opportunities to buy 50-cent
dollars, but when it returns to favor, one can sometimes sell such dollars
for $2, $3, or more... Now that's a way to make real money!
-4-Excerpt from A Google Skeptic Eats Crow, 11/21/14
My Worst Call Ever (2)
• However, of Google I wrote: :
• Dell vs. Google vs. McDonald's
Regarding the former, there's a huge difference between, say, Dell and
Google. While both are lumped into the tech sector, I would argue that Dell
is primarily a manufacturing/assembling, sales and service business, not a
technology company. Dell doesn't really care which hardware and software
products win the technology wars -- it simply buys, assembles, sells, and
supports whatever its customers want. In short, I think the odds are very
high -- say, 80%-90% -- that Dell is a major computer company in 20
years. (This is not to say that I recommend buying Dell stock -- as much as
I admire the company, I wouldn't buy it at half of today's price.)
Google, in contrast, is a more typical tech company -- one that must invest
heavily to remain on the cutting edge or its customers will quickly and
easily flock to competitors. Just as Google came out of nowhere to unseat
Yahoo! as the leading search engine, so might another company do this to
Google. I admire Google and what it has accomplished -- and I'm a happy
user -- but I am quite certain that there is only a fairly shallow, narrow moat
around its business.
[continued]
-5-Excerpt from A Google Skeptic Eats Crow, 11/21/14
My Worst Call Ever (3)
Think about it. What are the odds that it is the leading search engine in five
years (much less 20)? 50/50 at best, I suspect, and I'd wager that odds are
at least 90% that its profit margins and growth rate will be materially lower
five years from now. Yet investors appear ready to value this company at
as much as $36 billion, nearly 200 times trailing earnings! Google with the
same market cap of McDonald's (a stock I own)?! HA! I believe that it is
virtually certain that Google's stock will be highly disappointing to investors
foolish enough to participate in its overhyped offering -- you can hold me to
that.
-6-Excerpt from A Google Skeptic Eats Crow, 11/21/14
I Was Right That Margins Would Decline…
90%
Gross Margin %
80%
EBIT Margin %
70% Net Income Margin %
60%
50%
40%
30%
20%
10%
0%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 TTM Q3
'14
-7-Excerpt from A Google Skeptic Eats Crow, 11/21/14
…But Totally Wrong About Growth
Revenue has grown more than 20x since 2004
$70
$60
($B)
$50
$40
$30
$20
$10
$0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 TTM Q3
'14
-8-Excerpt from A Google Skeptic Eats Crow, 11/21/14
Revenue Growth Has More Than Offset Declining
Margins, Resulting in Phenomenal Growth in Earnings
$14 $20
Earnings from Cont. Ops. $18
$12
Diluted EPS Excl. Extra Items $16
$10 $14
$12
$8
EPS
EFCO ($B)
$10
$6
$8
$4 $6
$4
$2
$2
$0 $0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 TTM Q3
'14
-9-Excerpt from A Google Skeptic Eats Crow, 11/21/14
Google’s Stock Has Increased By More
Than 10x Since My Misguided Call
-10-Excerpt from A Google Skeptic Eats Crow, 11/21/14
What Did I Miss?
• I was completely wrong that Google has “only a fairly shallow, narrow
moat around its business”
• Google has a very powerful virtuous cycle at work:
High Large
Barriers User
to Entry Base
Large
Best • Network Effects Advertiser
Product • Economies of Scale Base
• Winner-Take-All
Most Better
R&D Monetiz-
Dollars ation
-11-Excerpt from A Google Skeptic Eats Crow, 11/21/14
The Bull Case: New Platforms Continue to
Create New Revenue Streams
Google Revenue ($B)
66
55 New Revenues:
• Mobile Search
• YouTube
40% CAGR 36
25 • Display
• Maps
• Android / App
Store
30
35 Old Revenues:
31% CAGR • Desktop
3 Search
2004 Revenue 2014E
2013E Revenue
-12-Excerpt from A Google Skeptic Eats Crow, 11/21/14
How Google’s Stock Could Double in the
Next Four Years
Drivers: Valuation in Four Years:
• Grow search ~10% • Revenue growth of ~20%
annually • Maintain margins
• Grow display ads ~25% • P/E multiple remains
annually constant ~20x
• Grow YouTube ~30% • Results in the stock
annually doubling over four years
• Grow new products
(Google Play, etc.) ~40%
annually
Note: This slide and the previous two are from the presentation of a friend who wishes to remain anonymous.
-13-Here’s What Alphabet Has Done Since My 2014 Presentation
Margins Have Remained Stable
90%
Gross Margin %
80%
EBIT Margin %
70% Net Income Margin %
60%
50%
40%
30%
20%
10%
0%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
-15-Strong Revenue Growth Has Continued
Revenue has now grown 35x since 2004
$220
($B)
$170
$120
$70
$20
-$30
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
(e) (e) (e) (e)
-16-Phenomenal Earnings Growth Has Continued
$50 $70
$45 Earnings from Cont. Ops.
$60
$40 Diluted EPS Excl. Extra Items
$50
EFCO ($B)
$35
EPS
$30
$40
$25
$30
$20
$15 $20
$10
$10
$5
$0 $0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
(e) (e) (e) (e)
-17-Alphabet’s Stock Has Continued to Rise
-18-Alphabet Today
Valuation of the Stock Today
• Stock price (2/26/18 close): $1,143.70 (GOOGL)
• Market cap: $795 billion
• Cash & STI: $102 billion ($147/share)
• Debt: $4 billion
• Enterprise value: $686 billion
• TTM EPS* and P/E: $32.01, 35.7x
• 2018 est. EPS and P/E: $41.45, 27.6x
• TTM EBITDA and EV/EBITDA: $40.7 billion, 19.5x
• 2018 est. EBITDA and EV/EBITDA: $51.6 billion, 15.4x
* All EPS numbers include stock-based comp
-20-Q4 ‘17 Earnings Were Very Strong
• Revenue up 24%
• Operating income up 15%
• Aggregate paid clicks up 43%
-21-Year-Over-Year Revenue Growth Has Been
Accelerating Over the Past Three Years
40%
35%
30%
25%
20%
15%
10%
5%
0%
-22-Alphabet Is Not Capital Intensive –
Most Cap Ex Is Investing in Growth
Cap ex as a % of operating cash flow for selected companies
60%
50%
40%
30%
20%
10%
0%
Pfizer J&J Apple Microsoft Facebook P&G Alphabet Berkshire Amazon Exxon Mobil AT&T
Note: TTM through Q1 ‘17
-23-Why Did I Change My Mind and Buy Alphabet A Year Ago?
Why Didn’t I Buy Alphabet’s Stock
Long Ago?
• I use Alphabet’s products/services every day, so it’s not a circle
of competence issue
• Rather, it’s in part because the stock has always appeared
expensive me, using the traditional valuation metrics with which
I’m most comfortable
• But there are other reasons, rooted more in emotion than logic:
– As a contrarian and value investor, I don’t like owning what
everyone else owns
– I don’t like buying stocks that have already risen a lot (instead, I
prefer to bottom-fish among the beaten-down stocks of out-of-favor
companies, betting that they can turn things around)
– I felt extreme regret for not having long ago purchased the stock of
this incredible company – a classic case of the “I missed it”
phenomenon
-25-The Emotional Aspects of Not Buying Alphabet
Became Clear to Me at the 2017 Berkshire Mtg
Buffett and Munger were asked, “…what have you learned about
investing in technology companies?” Munger answered that their
“worst mistake in the tech field” was not investing in Alphabet:
• Well, we avoided the tech stocks, but as we felt we had no advantage
there and other people did and I think that's a good idea not to play
where the other people are better, but you know, if you ask me in
retrospect, what was our worst mistake in the tech field, I think we were
smart enough to figure out Google. Those ads worked so much better
in the early days than anything else. So I would say that we failed you
there and we weren't smart enough to do it and didn't do it. We do that
all the time too.
-26-The Emotional Aspects of Not Buying Alphabet
Became Clear to Me at the 2017 Berkshire Mtg (2)
Buffett agreed that he “blew it” on Alphabet:
• We were their customer very early on with GEICO, for example; …as I
remember, we were paying them $10 or $11 a click or something like
that and any time you're paying somebody $10 or $11 every time
somebody just punches a little thing where you have no cost at all, you
know, that's a good business unless somebody's going to take it away
from you and so we were close-up seeing the impact of that.
…You know…you've…almost never seen a business like it. I
think [clicks] for LASIK surgery…were $60 or $70 a click with no
incremental…cost.
They [Google’s founders] came to see me…so I had plenty of
ways to ask questions or anything of the sort and educate myself, but I
blew it.
-27-The Emotional Aspects of Not Buying Alphabet
Became Clear to Me at the 2017 Berkshire Mtg (3)
• These comments led me to ask myself why, if Buffett and Munger admit
they “failed” shareholders and “blew it” by not buying Alphabet’s stock
in the past, they didn’t fix the mistake by buying Alphabet now?
• The simple answer, perhaps, is that Alphabet was cheaper then,
whereas they don’t think it’s cheap enough to buy today
• But I think there’s more to it than that. If Buffett had bought $10.8 billion
of Alphabet stock instead of IBM’s in 2011 and was sitting on a huge
gain (Alphabet’s stock has tripled since then), I highly doubt he would
be thinking about trimming, much less exiting, this position (even if
there were no tax consequences). Rather, I think he’d be delighted to
own nearly $40 billion of Alphabet stock right now and would view this
as one of Berkshire’s permanent stock holdings, like Coca-Cola, Wells
Fargo and American Express
• Triggered by this realization, I decided to take a fresh look at Alphabet
and a handful of similar companies
-28-My Conclusion: Alphabet Is One of the
Greatest Businesses on Earth
• I’ve been following Alphabet for years, so it didn’t take long to confirm
my long-held belief that it is among the greatest businesses on earth: it
dominates its sectors globally, is growing rapidly, has enormous,
sustainable competitive advantages in the form of brands, habits, and
network effects, and has a low-capital-intensive, high-margin business
models that generates gobs of free cash flow
• It has seven products with more than one billion monthly average users:
Search, Android, Maps, Chrome, YouTube, Google Play and Gmail
• Google Search has 90% share of search in most countries, Android has
~90% share of smartphones globally (vs. 5% in 2010), and YouTube
serves ~20% (and growing) of all video consumed on the internet
• Alphabet currently captures 14-15% of global advertising spending
-29-One Additional Data Point
• I gathered one important additional data point at the Berkshire
Hathaway meeting when I had the opportunity to speak for 20 minutes
with Martin Sorrell, the CEO of the largest advertising agency in the
world, WPP Group, and he confirmed a story I’d read that 100% of the
incremental ad spending in the world is going to Alphabet and
Facebook
• Stop and think about that for a second: countless companies are
competing for a share of this huge and rapidly growing pie (according
to one study, “global internet advertising expenditure will grow 13% to
reach $205 billion in 2017 and will attract 36.9% of all advertising
expenditure, up from 34.0% in 2016. This will be the first year in which
more money will be spent on internet advertising than advertising on
traditional television.”), yet only two companies are taking all of the
global growth, leaving every other company to compete in a zero-sum
game. This is simply astonishing…
-30-Alphabet Has Plenty of Room for Growth
• Enormous trend of advertising moving from traditional media to online
• Only ~12% of U.S. commerce is online today
• Smartphone penetration is only ~31% globally
• YouTube has enormous potential:
o The world’s second-most visited website (after Google.com), 80% outside of the U.S.
o Video appears to be at an inflection point, and Alphabet has arguably the most valuable
video platform in the world, as users watch 1.3 billion hours/day (5 billion videos/day)
and upload 300 hours of video every minute
o The average mobile viewing session lasts more than 40 minutes, up with more than
50% year-over-year
o Video is currently ~15% of Alphabet gross advertising revenue, growing at twice
Alphabet’s overall rate
o Opportunity to increase monetization, as YouTube serves ~20% of the web’s videos, yet
only ~10% of the web’s video ads
o In the U.S. YouTube currently monetizes at 60-70% the level of TV despite significantly
better targeting
o Annual revenue/user is slightly below Twitter despite having nearly 3x time spent/user
• If Alphabet spun off YouTube, how would the market value it?
o How it’s currently valued within Alphabet: $17 billion ($12 billion in revenue * 4% net
margin * 35x) = $25/share
o How it could be valued: $190 billion (assuming 40 cents/hour viewed, half of what cable
companies are valued at) = $270/share (source: Bill Nygren, VII, 5/17) -31-Alphabet’s “Other Bets” Depress Reported
Profitability
• Alphabet’s “Other Bets” segment includes Waymo (autonomous
vehicles), Nest (thermostats), Verily (life sciences & healthcare),
Access, Calico, CapitalG, GV, and X
• In 2017, Other Bets generated revenues of $1.2 billion (up 49% YOY)
and operating losses of $3.4 billion (down 6% YOY)
• Alphabet’s operating income in 2017 was $26.1 billion, so excluding
Other Bets, it would have been $29.5 billion or 13% higher
• Alphabet has invested ~$25/share into Other Bets; a conservative
estimate is that this could be worth ~$50/share or 4% of Alphabet’s
value
-32-But What About Valuation?
• It’s hard to argue that Alphabet is misunderstood, with 40 analysts
following the company, and equally hard to argue that its stock is cheap,
at 28x and 15x 2018 EPS and EBITDA estimates, respectively
• But those multiples aren’t crazy either, in light of the quality and growth
prospects of Alphabet’s core businesses
• They’re even less crazy if you adjust for various factors:
o If you subtract cash ($141/share) and the value of Other Bets ($50/share), and
add $2.7 billion ($3.89/share) to net income for after-tax losses on Other Bets,
Alphabet is trading at 21x 2018 earnings estimates – not far above the
average for the S&P 500, for a company that is vastly superior to the average
large U.S. corporation
o If you think YouTube adds $255/share of extra value, the P/E drops to 15x
• If revenues continue to grow at ~20% annually and margins and multiples
remain steady, then the stock will also grow at ~20% annually
• If you asked me to name 10 stocks that I think are most likely to
outperform the S&P 500 over the next five and ten years, Alphabet would
be on the list (after Berkshire Hathaway and Howard Hughes, to be sure),
so I’ve made a bit of room for it in my portfolio
-33-You can also read
